(A three-part series providing a US and UK perspective)
Why Are US Banks Interested in Synthetic Securitizations?
A US bank may be interested in a synthetic securitization for a variety of reasons, including risk mitigation through the sharing of credit risk with investors or financing assets that cannot easily be sold or transferred in a traditional securitization. However, the primary reason for engaging in a synthetic securitization is typically the release of capital.
Under the US capital rules,1 banks are able to reduce risk-based regulatory capital required for residential mortgage and other loan portfolios by converting exposures from wholesale or retail exposures to securitization exposures. This is due to the fact that the risk-weight under the US capital rules for typical senior securitization exposures is 20 percent, while the risk-weight for most other exposures is 100 percent for banks using the standardized approach.2 That means a senior securitization exposure can have required capital of 1/5 the amount required for holding a position in the unsecuritized loans. This result makes sense given that credit risk has actually been transferred in typical securitization transactions. However, in this regard, not all securitizations are treated equally, at least not under the US capital rules.
Operational Requirements under US Capital Rules
The operational criteria for traditional securitizations under US capital rules differ from those under the Basel framework in a way that can create a significant relative disadvantage to US banks. The operational criteria for traditional securitizations under the US capital rules require that the underlying exposures not be on the transferring bank's consolidated balance sheet under GAAP.3 In contrast, the Basel framework requires, among other requirements, that a traditional securitization include a transfer to third parties of a "significant credit risk associated with the underlying exposures," but does not require that the underlying exposures be removed from the transferring bank's balance sheet.
Unlike the operational criteria for traditional securitizations under US capital rules, the operational criteria for synthetic securitizations under the US capital rules do not require off balance sheet treatment (but do require some transfer of credit risk in the underlying exposures). As a result, engaging in a synthetic securitization and recognizing the use of a credit risk mitigant to hedge underlying exposures provides a potential means of capital relief.
Because a synthetic securitization does not remove the underlying assets from the balance sheet of the transferring bank, the bank will look to the rules regarding credit risk mitigation to determine the resulting capital treatment of the exposure it holds in relation to the transferred tranche of credit risk. This normally will be a zero risk-weight if the exposure is secured by financial collateral (i.e., cash on deposit including cash held by a third-party custodian or trustee) or it will be a risk-weight corresponding to the risk weight for the counterparty providing the guarantee or credit derivative, if that counterparty is an "eligible guarantor"4 under the US capital rules.
As an initial matter, in order to constitute a "synthetic securitization," as defined in the US capital rules, a transaction must meet the following requirements:
- All or a portion of the credit risk of one or more underlying exposures is transferred to one or more third parties through the use of one or more credit derivatives or guarantees;
- The credit risk associated with the underlying exposures has been separated into at least two tranches that reflect different levels of seniority;
- Performance of the securitization exposures depends upon the performance of the underlying exposures; and
- All or substantially all of the underlying exposures are financial exposures (such as loans, commitments, credit derivatives, guarantees, receivables, asset-backed securities, mortgage-backed securities, other debt securities, or equity securities).5
In addition, the bank must also satisfy the operational requirements for synthetic securitizations,6 including that the credit risk mitigant is one of the following three options: (1) financial collateral, (2) a guarantee that meets all criteria as set forth in the definition of "eligible guarantee"7 (except for the criteria in paragraph (3) of the definition) or (3) a credit derivative that meets all of the criteria as set forth in the definition of "eligible credit derivative"8 (except for the criteria in paragraph (3) of the definition of "eligible guarantee."
Because the operational criteria for synthetic securitizations recognize guarantees and credit derivatives as permissible forms of credit risk mitigants, those structuring a US capital relief trade (CRT)9 structured as a synthetic securitization typically will find themselves debating between a guarantee or a credit derivative, and this decision will involve a number of regulatory considerations, including compliance with insurance regulations, swap regulations, the US risk retention rules and the Volcker Rule. Below, we discuss a number of the legal structuring considerations relevant to a typical CRT structured as a synthetic securitization. The discussion is intended to highlight the primary legal structuring considerations that may be encountered in doing a CRT in the United States, but such considerations may not apply to all structures, and a CRT may give rise to additional legal, regulatory and accounting considerations not discussed in this article.
Insurance Regulatory Issues
One of the more challenging issues in structuring a CRT is navigating between avoiding insurance regulation on the one hand, and swap regulation on the other.
In the case of insurance regulation, the analysis is complicated by the fact that in the United States the business of insurance is primarily regulated at the state level, so whether a guarantee is an "insurance contract" subject to state insurance regulation will be a question of the applicable state's law—and how that law is interpreted by the state's insurance regulatory authorities. A further complication is determining which states' laws may apply to a transaction. Generally, insurance regulatory jurisdiction in the United States is based upon where the insurance contract (or putative insurance contract) is solicited, negotiated, issued and/or delivered.
Taking New York state as a representative example, an "insurance contract" is defined in N.Y. Ins. Law § 1101(a)(1) as any agreement or other transaction whereby one party, the "insurer," is obligated to confer a benefit of pecuniary value upon another party, the "insured" or "beneficiary," dependent upon the happening of a fortuitous event10 in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event. Under N.Y. Ins. Law §1101(a)(3), a CRT structured as a guarantee will face potential regulation as an insurance contract if made by a warrantor, guarantor or surety who is engaged in an "insurance business," which, as discussed below, is further defined in the New York insurance.
There is also a more specific definition of "financial guaranty insurance" in N.Y. Ins. Law § 6901(1)(a), which includes, among other things, a surety bond, insurance policy or, when issued by an insurer or any person doing an insurance business (as defined below), an indemnity contract, and any guaranty similar to the foregoing types, under which loss is payable, upon proof of occurrence of financial loss, to an insured claimant, obligee or indemnitee as a result of various events, one of which is the failure of any obligor on or issuer of any debt instrument or other monetary obligation to pay principal or interest due or payable with respect to such instrument or obligation, when such failure is the result of a financial default or insolvency.
Under N.Y. Ins. Law § 1101(b)(1)(B), whether a guarantor is engaged in an insurance business depends on whether it is "making, or proposing to make, as warrantor, guarantor or surety, any contract of warranty, guaranty or suretyship as a vocation and not as merely incidental to any other legitimate business or activity of the warrantor, guarantor or surety .... " The most recent interpretive authority for when a guaranty is not conducted "as a vocation" but is "merely incidental" is a 2003 opinion issued by the Office of General Counsel of the New York State Insurance Department.11 Under the reasoning articulated in that opinion, an "incidental" guaranty includes a guaranty by a parent company of a subsidiary's obligations, a personal guaranty by a shareholder of a closely-held corporation's obligations and a loan guaranty offered by a cooperative corporation to its owner-members for a nominal fee. By contrast, where a guaranty is provided to unrelated third parties, covers obligations of unrelated parties and is provided for a risk-based fee, that seems more like a "vocation"—and if a special purpose entity (SPE) provides the guaranty as its sole function, that would seem even more like a "vocation."
The consequence of a contract falling within the above definitions of "insurance" or "financial guaranty insurance," or of being a guaranty that is conducted as a vocation and not merely incidental to any other legitimate business or activity of the guarantor, is that the guarantor could be deemed to be engaged in an unauthorized insurance business and therefore subject to civil, and theoretically even criminal, penalties.
Notwithstanding the above, arguments could be made as to why a guaranty may not be insurance under applicable state law. For example, if a CRT does not require the beneficiary or protection buyer, as applicable, to own the underlying exposures, the instrument would generally not meet one of the defining characteristics of insurance, which is that the beneficiary have an insurable interest in the underlying exposures.12
In addition, in cash collateralized CRTs, the guarantor arguably does not have any future obligation to confer a benefit of pecuniary value, because it has satisfied all of its obligations upon the furnishing of cash collateral and has no future payment obligations. It should be noted, we are not aware of any insurance department having approved of such interpretation, and those structuring CRTs will need to consult with insurance counsel in applicable jurisdictions.
1. The EBA Draft Report on Synthetic Securitization, EBA/Op/2015/26
2. Regulation (EU) 2017/2402 of the European Parliament and of the Council of December 12, 2017 laying down a general framework for securitization and creating a specific framework for simple, transparent and standardized securitization, and amending Directives 2009/65/EC, 2009/138/EC and 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012
3. Regulation (EU) (575/2013) of the European Parliament and of the Council of June 26, 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012
4. Regulation (EU) No 648/2012 of the European Parliament and of the Council of July 4, 2012 on OTC derivatives, central counterparties and trade repositories, as amended, and its related regulatory technical standards
5. Regulation (EU) 2017/2401 of the European Parliament and of the Council of December 12, 2017 amending Regulation (EU) No 575/2013 on prudential requirements for credit institutions and investment firms
6. Question ID 2014_768 of EBA Single Rulebook Q&A; EBA Report on CRM Framework, March 19, 2018, paragraph 36.
7. Article 242(17),(18)
8. Assisting in performing or administering a contract of insurance is a regulated activity under article 39A of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (the "Regulated Activities Order").
The authors appreciate the assistance of Paul Forrester, a partner at Mayer Brown, and Harjeet Lall, an associate in the London office of Mayer Brown
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